INCOME FUNDS - CONTRA BETS

Income and Gilt funds which have performed badly over the past three years could be attractive contrarian bets for medium term investors. Income funds predominantly invest in highly rated paper of reputed companies, with almost 80 % of their investments being in AAA bonds. Gilt funds predominantly invest in Government securities.

Bond funds have given the following lackluster performance over the past 3 years:

Medium term Bond Funds Sector Average 4.95 % 5.89 % 5.22 %
Long and Medium Term Gilt Funds Average 4.64 % 5.84 % 5.04 %

Returns are as on 25th July 08 and are for 1,2 and 3 years, annualized.

Since interest rates in the Indian economy have been steadily rising over the past year or so, most of these funds have underperformed. A majority of the holdings of these funds being long term in nature, they have been severely marked to market downwards and as a result their capital values have eroded.

However during the credit policy on the 29th of July, 08, the RBI governor has given some hints that interest rates have peaked. Since he expects inflation to remain at current levels for the near future and ease off to 7 % by March 09, barring major shocks in the form of a huge jump in international commodity prices, there should be no reason to increase interest rates any further. If inflation does start to cool off by the beginning of 09, due to various factors like slowing demand for commodities, higher base effect, effect of past monetary tightening etc., then interest rates should stabilize at current levels and then start to fall off. Again hints of a slowdown in the economy makes lowering of interest rates of prime importance.

This could result in a surge in bond prices with a consequent increase in the NAV’ of income and Gilt funds. In fact interest rates do not even have to actually fall, for bond prices to rise. Just an indication from various parameters that interest rates are likely to cool off is sufficient to trigger a rally in prices of bonds. Markets discount the event well in advance and as a result well before interest rates actually fall, bond prices would start to rise. Depending on the sharpness of the fall in interest rates, bonds could deliver handsome returns from present levels.